Exchange Rate and Puchasing Power Parity Theory - Essay Example

Here, we will take a look at the concept that is the purchasing power parity and try to understand its implications on the currency exchange rates in the world. The best simplest way to describe Purchasing Power Parity, denoted by PPP, is by directly going into its application. So, PPP of the Gross Domestic Product for the countries around the world as of 2003, where we use the American economy as our base group and assign it a value of 100 would see the highest index value being appropriated to Bermuda i.e. 154.

This basically means that goods that are sold in the Bermuda are 54% times more expensive as compared to those in United States. Now, the purchasing power parity theory makes use of the long term equilibrium exchange rate that exists between these two currencies in order to equalize the purchasing abilities of both the said currencies. This theory has been developed by the works of Gustav Cassel in 1920 and to put it in simplest terms, it is fundamentally the law of one price: the theory goes along the lines that in completely ideal and efficient markets, identical goods must have the same price regardless of the currency used in the purchase of goods.

By equalizing the purchasing power of different currencies in their home countries for a given basket of goods for different currencies, we can ascertain the purchasing power SEM rate. . t are existent in a country as well as the similar rates of inflations from different countries as opposed to a generic nominal gross domestic product comparison. It is also a generally accepted notion that the most widely accepted and most often applied purchasing power parity exchange rate is the Geary-Khamis dollar; which is also known as the "international dollar".

Changes in the PPP exchange rates: Purchasing power parity exchange rates; or what are known as 'real exchange rates' most often experience variability due to the exchange rate movements that taken place due to open market currency operations. Notwithstanding this type of value fluctuations, uniform variations of the market and the purchasing power parity exchange rates are observed. We have the example of the market exchange rates, which are usually priced for non-traded goods and services at a lower level than expected in the instances where the national incomes are also relatively low.

This basically means that a U.S. dollar that is exchanged in Dubai for their local currency and then used to purchase body massages will buy a greater number of body massages as opposed to using the same U.S dollar in the United States to buy body massages. Purchasing Power Parity takes into account this lower cost of living in Dubai and makes specific adjustments in order to for it to appear as if the entire income was being consumed in the local country. From another viewpoint purchasing power parity is the number of a certain set basket of basic goods that can be purchased in a given country with the money that is produced by the said country.

PPP exchange rates and the market exchange rates: There can be immense differences between the purchasing power parities and the market exchange rates between any set of